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Friday, August 7, 2015

The Monetary Superpower Strikes Again

China's economy has been slowing down for the past few years and many observers are worried. The conventional wisdom for why this is happening is that China's demographic problems, its credit binge, and the related malinvestment have all come home to roost. While there is a certain appeal to these arguments, there is another explanation that I was recently reminded of by Michael T. Darda and JP Koning: the Fed's passive tightening of monetary policy is getting exported to China via its quasi-peg to the dollar. Or, as I would put it, the monetary superpower has struck again.

The Fed as a monetary superpower is based on the fact that it controls the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Therefore, its monetary policy is exported across the globe and makes the other two monetary powers, the ECB and Japan, mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar. As as result, the Fed's monetary policy also gets exported to some degree to Japan and the Euro. This understanding lead Chris Crowe and I to call the Fed a monetary superpower, and idea further developed by Collin Gray. Interestingly, Janet Yellen implicitly endorsed this idea in a 2010 speech:

For all practical purposes, Hong Kong delegated the determination of its monetary policy to the Federal Reserve through its unilateral decision in 1983 to peg the Hong Kong dollar to the U.S. dollar in an arrangement known as a currency board. As the economist Robert Mundell showed, this delegation arises because it is impossible for any country to simultaneously have a fixed exchange rate, completely open capital markets, and an independent monetary policy. One of these must go. In Hong Kong, the choice was to forgo an independent monetary policy.

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As in Hong Kong, Chinese officials are concerned about unwanted stimulus from excessively expansionary policies of the Fed and in other developed economies. Like Hong Kong, China pegs its currency to the U.S. dollar, but the peg is far less rigid.

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Overall, we encountered concerns about U.S. monetary policy, and considerable interest in understanding the Federal Reserve's exit strategy for removing monetary stimulus. Because both the Chinese and Hong Kong economies are further along in their recovery phases than the U.S. economy, current U.S. monetary policy is likely to be excessively stimulatory for them. However, as both Hong Kong and the mainland are currently pegging to the dollar, they are both to some extent stuck with the policy the Federal Reserve has chosen to promote recovery.

The original context of the monetary superpower argument was that the Fed was exporting its easy monetary policy to the rest of the world in the early-to-mid 2000s. Now the argument is that its normalization of monetary policy is creating a passive tightening of monetary conditions for the rest of the world, especially the dollar peggers like China.

So what evidence is there for this view? First, note that China's accumulation of foreign reserves begins to slowdown at the end of the pre-taper portion of the Fed's QE3 program, something that also happens with the other QE programs:

A slowdown in reserve accumulation means a slowdown in domestic money base creation and a tightening of monetary conditions more generally. A close look at the figure shows this slowdown accelerated in mid-2014. So what happen at that time?

This next figure suggests it was an increased tightening of U.S. monetary policy starting around mid-2014. This development can be seen in the rising values of the 1-year treasury rate (an average of expected short-term rates over the next year plus a small term premium) and the trade weighted value of the dollar. Both amount to a passive tightening of monetary conditions that in turn got transmitted into China.

The trade weighted dollar is just one indicator of the stance of U.S. monetary policy. But it seems to be an important one when looking at the U.S. monetary policy-China link over the past decade. It tracks the growth of China's nominal GDP relatively closely during this period.

So it appears the monetary superpower has struck again. Maybe it is time for dollar peggers like China to recognize that your tango partner may not have your best interests in mind.

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"As in Hong Kong, Chinese officials are concerned about unwanted stimulus from excessively expansionary policies of the Fed and in other developed economies."

This is rich: Hong Kong is concerned about "excessively expansionary policies of the Fed and in other developed economies" when those "excessively expansionary" policies had not returned and showed no sign or returning NGDP to its pre-crisis trend! AND the peg, if it was detrimental, could be moved at their discretion,

"A good place to start is by considering the relative weights of the currencies in TWEXBPA.

The three currencies with the greatest weights are the Chinese renminbi (21.3%), the euro (16.4%) and the Canadian dollar (12.7%). To estimate the real exchange rate (RER) of each of these currencies in terms of the US dollar I computed the ratio of the Bank for International Settlements (BIS) Real Broad Effective Exchange Rate for each currency area divided by the BIS Real Broad Effective Exchange Rate of the US. I term these ratios RERCHUS, REREUUS and RERCAUS.

The next thing I did was check to see if the US monetary base Granger causes the RER of these currencies in terms of the US dollar during the period from December 2008 through May 2015.

Not only does the US monetary base not Granger cause RERCHUS, the p-value for the non-causality test is an amazingly high 99.15%. Of course the IMF has classified the exchange rate arrangement of China as a “crawl-like arrangement” (page 6) with a “de facto exchange rate anchor to the US dollar” (see footnote) since 2007.

The Granger causality test result supports this classification, and in light of it, perhaps the exchange rate arrangement of China should really be termed a “crawl-like peg”.

In any case, to do further analysis of RERCNUS I would need to know China’s monetary base and overnight repo rate, and personally I find the website of the People’s Bank of China even less user friendly than the Bank of England’s web site used to be. So I’ll leave it until a later date, and for now, based on the near 100% value of the above p-value, I’ll assume that the outcome of my efforts will end up in grim defeat anyway."

I agree that the Chinese peg is a dirty one. That is why I called it a quasi-peg above. For some periods it has been rigid, other times it has gradually appreciated. Ironically, over the past year it has been relatively rigid lately making the tightening of US policy pass through with great virility. And to be clear, I used the nominal trade weighted effective exchange rate, not the real version.

I would also be careful with looking at changes in the monetary base and its affect on the Chinese economy. As the chart above of 1 year interest rates and the dollar value shows, monetary conditions are already tightening in anticipation of the Fed's tightening. This is being felt in China now even though the monetary base hasn't changed much.

"I would also be careful with looking at changes in the monetary base and its affect on the Chinese economy."

To be clear, that's not at all what I am doing.

I briefly contemplated looking at the *effect of changes in the monetary base on the real exchange rate of the renminbi*, but as the Granger causality test results imply, China effectively has a peg, so that renders it essentially impossible.

"As the chart above of 1 year interest rates and the dollar value shows, monetary conditions are already tightening in anticipation of the Fed's tightening. This is being felt in China now even though the monetary base hasn't changed much."

Or has 1-year rates and the dollar value risen because the monetary base hasn't changed much?

In the age of ZIRP the monetary base performs quite well as a predictor of the dollar value, and creditably well as a predictor of 1-year interest rate. (And why shouldn't it? After all it signals the FOMC's intentions.) The monetary base peaked in August 2014. The dollar has been rising since July 2014 and the 1-year rate has been rising since October 2014.

"Or has 1-year rates and the dollar value risen because the monetary base hasn't changed much?" That is a fair point. Relative to where the monetary base had been growing this relative decline could arguably be the tightening of policy.

While looking at David's charts and reading his post I was thinking to myself "I wonder if this is a spurious correlation? Are those stationary time series? What about 1st differences? I wonder what Sadowski's Granger causality analysis would say?" ... and here's the man himself to let us know, Lol.

Why is China so reluctant to devalue? Could someone please provide a more thorough explanation than this?

“This relief is blocked – for now – because it would risk other nasty side-effects. Chinese companies have $1.2 trillion of US denominated debt. A yuan devaluation would anger Washington and risk a beggar-thy-neighbour currency war across Asia, with lethal deflationary effects.”

TravisV, that seems like a reasonable answer to me, but I am not sure what is the least worst path for China to take. If it stays on present course it imports U.S. monetary policy and further constricts its own economy. Given its size this could further weaken the global economy. The argument above implies that if it devalues it will create deflationary forces across the globe that may also be bad. Pick your poison.

Is your second chart suggesting that a 20bp increase in the 1-year treasury caused a 20% appreciation of the dollar? That seems highly implausible, as becomes apparent if you look at the same chart over a longer time span. I highly doubt recent tightening has had any effect on China.

However, I think there IS a connection, albeit not the one you suggest. It is likely that, had China allowed its currency to float, it would have seen substantial appreciation relative to the dollar after 2009 (since China was relatively unaffected by the global recession). By keeping its currency low, China followed an excessively expansionary policy after 2008, which likely contributed to its recent bubble-fueled growth.

Thus any tightening by the Fed would involve China importing a more appropriate policy. And in fact, China doubtless wants the US to recover (which will involve raising interest rates) because this will likely increase demand for imports. Asymmetric shocks are bad news with a fixed exchange rate.

To expand briefly on why it doesn't make sense to interpret the recent appreciation of the dollar as a result of an exogenous shock to monetary policy:

The channel through which such a shock would cause appreciation is through capital flows: i.e. the Fed would raise r, this would prompt capital inflows, and this would appreciate the dollar until NX fell to match the capital inflow. But to see such a large appreciation would require a very large interest-elasticity of capital flows, AND a very low interest-elasticity of exports, which are both contrary to most estimates.

Not to mention that there is no evidence otherwise of a monetary policy shock in the US on a scale that would cause a 20% appreciation. This would cause deflation (or disinflation), a rise in unemployment, etc.

A much more plausible explanation of the appreciation is that the US has been doing well recently relative to the rest of the world. The US is having a decent recovery, while Europe is in bad shape, and emerging economies have had some trouble recently. This has prompted capital inflows to the US, and simultaneously caused the Fed to start consider tightening monetary policy. But if anything, the weakness in the rest of the world (as evidenced by the capital inflows and appreciation) is a primary factor delaying the Fed's tightening!

Jonathon, your forgetting two things. First, it is the expectations of tightening that matter. Second, it is also an issue of tightening relative to other big CBs like ECB which is easing. These two developments are why most observers DO tie the rise of the dollar to the expected tightening cycle of the Fed.

China doesn't produce its own credit, it cannot, it lacks the infrastructure.

UK, Japan and the US can produce credit: they have national treasuries, central banks, strong commercial banks, rule of law, enforceable contract- and property rights, a means of settlement, a national currency that freely trades in overseas currency markets.

China has these except for rule of law, enforceable contract- and property rights, a means of settlement, a national currency that freely trades in overseas currency markets. It's a (corrupt) communist dictatorship with arbitrary and capricious ruling cadre that does what and when it pleases. It relies on overseas funds as collateral for its own currency/credit issue.

Because China is not a credit provider it relies entirely on the credit of others, it this case mostly dollars gained from 'goods' sales (loans made to US customers) as well as euros and yen. When these funds flow out of China or when Wall Street decides to stop lending to US customers or when those customers have had their fill of worthless Chinese garbage there will be no more collateral for Chinese funds issued either by the PBoC or by China's 'loan shark' lenders.

As the bulk of China's loans are revealed as unsecured the country faces a margin call, hence the demand for dollars and the sales of US Treasury bonds by China.

The Fed has nothing to do with this, the process began -- and will end -- on Wall Street.

As to China, it is the MOST UNPRECEDENTED AND PATHETIC CREDIT / DEBT CATASTROPHE in the entire history world and is now coming crashing down as it TOTALLY IMPLODES IN ON ITSELF with only China to blame for that.

China is a ludicrous, laughable, and preposterous CREDIT BUBBLE WRECKAGE. The renminbi has ZERO CREDIBILITY AS A CURRENCY. Are you not aware that China "printed" $23 trillion in renminbi over the past 10 years and that China is BY FAR THE MOST EGREGIOUS MONEY PRINTER IN THE WORLD.

During the same time that China increased its money supply by $23 TRILLION, the Federal Reserve only increased the MONETARY BASE (not the money supply) in the US by $3 trillion China's economy is about HALF THE SIZE OF THE US.

China has NO BANKING OPERATIONS IN THE US other than a single branch of the PBOC in New York with a very limited correspondent branch in Los Angeles.

China created over $23 TRILLION IN NEW MONEY to do so making China by far the MOST EGREGIOUS MONEY PRINTER IN THE WORLD and they created an unprecedented debt bubble as a result of their unprecedented credit and money creation spree and it is now imploding.

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